The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been fragile and unbalanced. Now, with the subprime mortgage crisis and the ongoing deflation of the house price bubble, there are signs that the expansion may be ending.

Many observers blame the recent crises on the Federal Reserve, claiming the Fed promoted excess in the credit and housing markets by keeping interest rates too low for too long. However, the reality is that low interest rates were needed to sustain the expansion. Instead, the root problem has been a distorted expansion caused by record trade deficits and manufacturing's failure to fully participate in the expansion.

If the Fed deserves criticism, it is for endorsing the policy paradigm underlying these distortions. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.

By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Following an extended period of jobless recovery, private sector job growth has been below par. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.

This gloomy picture justified the Fed in keeping interest rates low. But why the economic weakness—despite historically low interest rates, massive tax cuts in 2001, and huge increases in military and security spending triggered by 9/11 and the Iraq war?

The answer is the overvalued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion or 6.5% of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing's weak participation in the expansion. Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have cut back on investment owing to weak demand or have moved their investment to China and elsewhere. These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened consumer demand and, hence, job creation.

The evidence is clear. Manufacturing has lost an unprecedented 1.8 million jobs during the current expansion. Before 1980, manufacturing employment hit new peaks with every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. In this business cycle, manufacturing employment has fallen during the expansion. The business investment numbers tell a similar dismal story, with much weaker capital spending than in previous expansions.

These conditions compelled the Fed to keep interest rates low in order to maintain the expansion. That policy worked, but only by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5% of total employment, has provided over 12% of job growth. Meanwhile, higher house prices have fuelled a home-equity borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.

The overall picture is one of a distorted expansion in which manufacturing continued to shrivel while imports and services expanded. The expansion was carried by the bubble in house prices and the rising burden of consumer debt, both unsustainable. That contradiction has surfaced with the implosion of the subprime mortgage market and deflation of the house price bubble.

The Fed is now trying to assuage markets to keep credit flowing. It has recently lowered interest rates and will lower them further if the economy continues to slow. On one level that is the right response, and it may even work again—though more and more it is coming to seem like sticking a finger in the dike. But the deeper problem is the policy paradigm behind the distorted expansion; this is where the Fed—along with a wide swath of federal policymakers and politicians—is at fault.

The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the unbalanced expansion policies coming out of the White House and the Treasury Department. The Fed's professional economists also seem to have endorsed corporate globalization in the name of free trade, dismissing the sharp drop-off of domestic manufacturing as inconsequential. Thus, the Fed has tacitly supported the underlying policy paradigm that has given rise to the U.S. economy's distorted expansion. Despite talk about reducing global financial imbalances, the Fed under Chairman Ben Bernanke still seems locked into this paradigm, which is where constructive criticism should now be directed.

Thomas Palley is an economist in Washington, D.C. His weekly policy blog (where a version of this article originally appeared) is published at www.thomaspalley.com. He is also the author of Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism (Princeton University Press) and Post-Keynesian Economics (Macmillan Press). He has held positions as chief economist of the U.S.-China Economic and Security Review Commission, director of the Open Society Institute's Globalization Reform Project, and assistant director of public policy at the AFL-CIO.